The unorthodox route out of monetary purity

Reserve Bank governor Graeme Wheeler is likely to leave the official cash rate unchanged at 2.5 per cent on Thursday. That is, he will leave it at the emergency level to which it was cut after the February 22 Christchurch earthquake to insure against a plunge in confidence.

Wheeler is in top company. Nearly six years after the United States derivatives market began to tank, bestowing on us the global financial crisis (GFC), big-rich-country central banks are still at battle stations, shovelling out money through “quantitative easing”, holding their official interest rates near zero and jawboning to calm nerves and/or lift spirits.

The United States and Japan official rates are a whisker above zero. Last week the Bank of England and the European Central Bank (ECB) left their rates at record lows of 0.5 per cent and 0.75 per cent respectively. These low rates are part of the reason sharemarkets have boomed. Mighty River shares will be in hot foreign demand.

The United States Federal Reserve has said it will keep printing money at $US85 billion a month until unemployment has dropped to a level it thinks reflects durable GDP growth. Japan’s new government has strong-armed the Bank of Japan into boosting inflation to end two decades of stagnation. The ECB caved in last year to demands for bank bailouts. Incoming Bank of England governor Mark Carney canvassed alternative targets to inflation, though he has recently moderated his language.

All this has devalued big-rich-countries’ currencies, which has pushed up the currencies of small rich countries and commodity countries to unsustainably high levels. Some have tried to get them down. Australia has not but on February 26 Reserve Bank assistant governor Guy Debelle said it could act if it chose: “We have more Australian dollars than anyone else because we print them.”

This is not what Milton Friedman had in mind when he argued in the 1960s for strict monetary control — monetarism, as it became known when politicians took it up from the late 1970s on. Friedman originally wanted central banks to control money supply but, because it was not clear which measure of money to target or how accurate the measures were, inflation came to be targeted as a proxy. Our Reserve Bank under Don Brash was the first to apply the pure form of this inflationist proxy.

But inflationism went awry in the 1990s and 2000s when computerisation and China’s impact on global manufacturing were driving prices down — or should have been — and central banks still allowed prices to go on rising. Debt boomed. Money supply blew out. We got house and financial bubbles, then the GFC — and then central banks cut loose.

Those wedded to the Friedman orthodoxy present this as a temporary aberration, implying that when “recovery” comes central banks and other officials will return to pre-GFC orthodoxies.

But the longer the aberration the less likely the return to orthodoxy.

There is now serious intellectual and political argument both for adjustments to the Friedman orthodoxy and for a different orthodoxy — though no agreement yet. The websites of the likes of the Financial Times or the Economist bustle with exploring economists and commentators. One line says the unorthodox measures have stopped working and more is needed. There are also debates about what will happen to bonds and budgets when central banks stop printing money, lift official rates and try to clean up their bulging balance sheets.

Across in real-people-land voters are turning against incumbent governments, many of them to left, right or wacky populists — 15 per cent in Italy’s election voted for a movement formed by a comedian. In the United States and Europe this is destabilising politics, challenging mainstream officials and politicians and the fiscal stringency needed for the old monetary orthodoxy to work.

The Friedman restorationists have an uphill political fight. There is now much debate about how independent of politicians central banks actually are — or can be.

Here David Parker (mainstream centre left), Russel Norman (established left) and Winston Peters (populist, but now relatively tame) are pushing various monetary management alternatives. They interpret big-rich-country central banks’ lengthening departures from orthodoxy as evidence of a permanent shift which New Zealand should emulate.

In fact, Wheeler has Bill English’s backing for a bigger role for four “prudential supervision” controls on banks, which could be used for other purposes: a counter-cyclical capital buffer against shocks like the GFC, a core funding ratio to reduce reliance on foreign funding, capital set-asides for risky sectors (farming is one) and loan-to-value restrictions (for example, for houses) aimed at nascent bubbles.

Wheeler has warned against over-excitement. But there is now a lot of light between him and the Brash era. That has emboldened the Parkers, Normans and Peters.

We may well be in a significant transition.